Making the case for alternative investments

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South African investors tend to be more risk-averse than their overseas counterparts, and for this reason have historically been underweight alternative investments that have a proven track record of providing yield lift, as well as returns that are not correlated to traditional markets, says Thato Mashigo, portfolio manager at Sanlam Private Wealth.

Traditional asset classes have become highly correlated of late and their returns can be quite volatile. From a portfolio construction perspective, there is growing pressure to find new sources of return to meet required outcomes.

This trend of declining returns from traditional asset classes is likely to persist in the medium to long term. This poses a challenge for asset managers.

“This suggests we need more education about the types of alternative investments that are available, including on their uses, benefits and risks,” says Mashigo.

Mashigo compares US and Asian investors who typically have 25-35% portfolio exposure to alternative investments, against South Africans who typically have less than 10%.

Regulation 28 of the Pension Funds Act limits pension funds to an exposure of no more than 15% in private equity and 10% in hedge funds.

“This means most South Africans are likely to have a heavy bias towards traditional investments such as listed stocks and bonds, and for this reason their returns are going to be highly correlated to overall market trends. A strong case can be made for increasing exposure to alternative investments that are not correlated to general markets trends, and to provide some yield enhancement.”

Alternative investments typically refer to assets such as cryptocurrencies, commodities, art, private equity, hedge funds, venture capital and private debt.

Alternative investments offer powerful risk-adjusted returns

Alternative or so-called ‘private market’ investments are typically unlisted and tend to have lock-in periods of five, seven or even 10 years and are therefore intended to be held for the long term. To compensate investors for this illiquidity, the assets offer the potential for higher returns than their more liquid counterparts.

This kind of illiquidity poses no real problem to retirement fund managers and insurance companies with long-term liabilities, and equally long-term investment horizons. They are able to benefit significantly from the illiquidity premium, investment flexibility, lower volatility and therefore powerful risk-adjusted returns that characterise alternative investment opportunities, according to Mashigo.

Cryptocurrencies have started to feature on the menu of options available to more traditional investors. Though the returns for bitcoin have been spectacular – averaging around 200% a year for the last decade – they come at extreme risk to capital. Mashigo says clients are able to gain direct exposure through one of several cryptocurrency exchanges, though this market is currently unregulated.

Those looking for exposure to cryptocurrencies in a more regulated environment can purchase shares in a Grayscale Bitcoin Trust product, which allows investors to invest in bitcoin without the associated custody and security issues. Grayscale recently applied to the US Securities and Exchange Commission to convert to an exchange-traded fund (ETF), which carries with it several operational and tax efficiencies.

An offshoot of the cryptocurrency market are non-fungible tokens (NFTs), which is unlocking huge wealth in the digital art space.

Until now, there was no reliable way of claiming ownership of digital art – NFTs change that, while still allowing unlimited numbers of people to view that art.

Mashigo says traditional art as well as NFTs will become more important to family offices and wealth managers going forward, though traditional art poses the problem of custody and maintenance – something that has been solved where NFTs are concerned.

Hedge funds have become a massive part of the investment landscape in the last two decades, with their promise of superior returns uncorrelated to market conditions. Some of these funds specialise in buying distressed assets, others (such as the hedge funds betting against US gaming company GameStop) take short positions against companies they believe to be overvalued.

Some take both long and short positions on companies in an effort to smooth out market returns over time. There are a variety of strategies that hedge funds can adopt. Mashigo says the last decade has been difficult for hedge funds in terms of relative returns. “Fund selectors manage this by allocating to top quartile managers who have shown good alpha persistence – outperformance against a chosen benchmark – over time.”

Another alternative asset class offering yield pick-up in a low yield environment is private debt.

“This is not typically available to the ordinary investor, only to high-net-worth individuals. This is one way to get inflation-beating returns at relatively low risk, particularly in an environment where interest rates are as low as they are right now,” says Mashigo.

Private equity and venture capital round off the menu of offerings for investors. Here the lock-up periods can be five or seven years, sometimes longer, but with the promise of some outstanding long-term returns that are not influenced by trends in the more traditional markets.

Combined, these alternative investments can help shield a portfolio from the shocks and turbulences of traditional markets, while staying true to the core investment principle of diversification and risk mitigation.

For further information, contact info@privatewealth.sanlam.co.za.

About Sanlam Private Wealth: The business was formed neatly 20 years ago, and has evolved from a small stockbroking firm to a holistic wealth management business with a strong track record, and assets under management and administration of more than R151 billion. Sanlam Private Wealth custom-crafts wealth solutions for high-net worth individual who require end-to-end solution that include global investment portfolio construction, intergenerational estate planning, cross-geographical tax structuring, equity-backed finance and traditional stockbroking.

Brought to you by Sanlam Private Wealth.

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